World markets are at crunch point

Gary Duncan: Economic view

The earth moved in global financial markets at the end of last week. After March’s sharp tremors across the world’s stock markets, this time it was the turn of the bond markets to shake up investors.

There now seems little doubt that we are approaching a watershed at which global financial conditions, which have been remarkably benign for a protracted period, are shifting to a new and more unpredictable dynamic – one with far-reaching repercussions.

To many observers, the events in the second half of last week will seem arcane. A sudden spate of heavy selling of longer-dated, ten-year US Treasury notes, fostered in part by technical adjustments in the hedging of Americans’ mortgage debt, triggered an abrupt jump in benchmark US bond yields.

Yet far from being arcane or irrelevant, last week’s moves are almost certainly the precursors of a global sea-change in financial markets that will wipe out the key assumptions underpinning dozens of high-risk investment strategies, and undercut the financial logic behind at least some of the present wave of highly leveraged corporate mergers.

It was not merely the scale and speed of the shift in bond markets on Thursday and Friday that hinted at its significance, but also the shattering of an historic trend that embodied the recent, prolonged era of abundant capital and low volatility that has proved so fertile for markets, investors, speculators, and corporate players.

On Thursday, as an aggressive sell-off ripped through the US Treasury bond market, the yield on benchmark ten-year notes burst back above 5 per cent in its steepest daily move for two years. Then, on Friday, the ten-year yield came within a fraction of reaching the key threshold of 5.25 per cent.

Crucially, these moves brought to an end a two-decade-long pattern of the bull market in bonds in which successive peaks in ten-year yields have been progressively lower. For many in the markets, the breaching of the 20-year trend was a spine-tingling moment – and rightly so. At the same time, we also witnessed the apparent unwinding of the famous “conundrum” highlighted by Alan Greenspan, of the persistence of very low long-term market interest rates.

To understand the implications, we need to consider what was driving these events.

Despite widespread assertions to the contrary, this does not really seem to have been a sudden flap about inflation dangers. The shift that took place was concentrated in real bond yields, with index-linked bonds barely affected. In addition, the move was not accompanied by any parallel jump in gold prices, which is what would have been expected if this was an inflation scare.

Instead, there seem to be two more credible, principal explanations here. The first is that the Treasuries market finally cottoned on to the likelihood that, with somewhat better than previously anticipated prospects for American growth, the Federal Reserve will not be cutting US official interest rates any time soon.

The second factor is that this sudden leap in US market interest rates reflects the sharp, worldwide slowdown in the past, very rapid expansion of global liquidity as all of the world’s key central banks (besides the Fed) tighten the interest rate screws.

This second factor is one reason why the surge in US benchmark bond yields was mirrored in the British, continental European and Japanese government bonds markets, too.

Where, then, do we go next? In the short-run, as we report this morning, analysts expect a further bout of bond market turbulence driven by the shift in US rate expectations. So much seems inevitable – as does some spillover of increased volatility into other asset markets.

What is not clear is whether the upward march of benchmark yields, in the US at least, will prove a decisive trend. In America, significantly higher yields, if they do persist, probably contain the seeds of their own destruction. As this rise in market interest rates intensifies the squeeze on an already weakened US economy, markedly raising the cost of capital for borrowers, a deeper slowdown in American growth will ultimately trigger a fresh reappraisal of the growth outlook that will send yields lower once more.

More crucially, however, as the chart above from Deutsche Bank suggests, the worldwide retreat of the past few years’ hugely abundant supply of capital, as central banks pursue their present push to curb liquidity growth, is set to persist. And it is this decisive shift to tighter global financial conditions that seems set drastically to reshape the market and corporate landscape.

The benign constellation of financial trends that has fuelled a global boom in assets of all kinds for the past five years is now breaking down.

The past global glut of cheap capital created by low official interest rates flooded into every corner of financial markets. As prices rose, and returns were depressed, the much-vaunted “search for yield” encouraged moves into ever riskier assets and strategies in a hunt for enhanced performance.

Much of this is, if not quite over, now coming to an end. And the adjustment to a new era will bring casualties as speculators are wrong-footed and miscalculations are unmasked.

It is not all bad news. The still buoyant global growth outlook that provides the rationale for higher official interest rates means that there should be some significant support for equity markets. But share valuations, which have been boosted by the merger boom, are still likely to face a rigorous test, while many riskier, speculative plays in the markets may implode.

As dearer money raises financing costs, the viability of some leveraged buyouts is likely, too, to be called into question.

If you thought you heard a crunch just then, you probably weren’t mistaken.

eBay takes its adverts off Google

eBay has pulled all its advertising from Google after learning of the search giant’s plan to gatecrash its user conference this week to promote Checkout, a rival to eBay’s PayPal payment service.

The online auction site, which is Google’s biggest advertiser by far, cancelled the adverts indefinitely after the search engine invited eBay’s largest sellers, in Boston for their annual convention, to a rival party.

Once at the party, which was scheduled for last night, Google planned to extol the virtues of its fledgeling Checkout online payment service.

But in a move that will give satisfaction to the growing army of Google-haters, the search firm cancelled the event on Wednesday night after eBay announced that it would cease advertising with the search engine.

The advertising debacle happened less than a month after Microsoft branded Google’s planned $3.1 billion (£1.6 billion) takeover of DoubleClick, the online advertising firm, as uncompetitive. Microsoft had made its own offer for DoubleClick, but lost out to Google.

Roger Kay, president of End-point Technologies, the US consultancy, said: “Google is the king of the hill and it is a natural human emotion to wish for the downfall of such a dominant company. The mantel has shifted from Microsoft to Google.”

After Google spent nearly $1.7 billion on YouTube, the video-sharing upstart, media companies such as Viacom, the owner of MTV, began to step up copyright infringement claims relating to the site. They had been largely ignored when it was owned by a bunch of former students.

Mr Kay said: “Google’s move seems mean spirited and underhand and I am surprised it stooped so low. But I’m glad eBay stood up to Google, although I don’t think eBay really needs to worry. Check-point isn’t doing that well and PayPal is the dominant method.”

eBay, whose PayPal services handle about 80 per cent of American internet transactions, spends an estimated $100 million a year advertising with Google. Some 188 million eBay ads appeared on Google in March, more than double the number for Target, the department store chain that is the search engine’s second biggest advertiser, according to com-Score Networks.

Analysts estimate that between 10 per cent and 20 per cent of eBay users are led to the site by Google adverts. But PayPal generated $1.4 billion of revenues last year, nearly a quarter of the group’s total sales, and eBay is concerned that rival systems such as Checkout could erode that business.

Why Advertising Isn't A Strong Business Model

I am proud to be a mentor for the Colorado TechStars program, and this evening we had our first mixer, a typical geeky mixup with poor acoustics and a male:female ratio of about 30:1. The mix was young entrepreneurs who won the TechStars competition and are now seed funded through the summer (along with gaining access to an array of very sharp advisors and mentors), the mentors, and other folk in the community who are focused on startups and business development.

A nice group and it was a good opportunity to both visit with some of my Denver-based friends and meet the young turks who are hopefully going to be building the next YouTube or Flickr in our proverbial garage.

Except for one glaring problem...

I estimate that I talked with about seven different startups this evening, roughly fifteen different entrepreneurs who are eager to dive into their business ideas full-time, to really devote all their energy into building Something Cool and Meaningful. Hopefully there's the proverbial pot o' gold at the end of the rainbow, but there was very little sense of people tilting towards a payout (or what we finance types call an "exit event"), which was nice.

But time after time, I asked "interesting idea, but how are you going to monetize it?" and received back flowery explanations that boiled down to "advertising" or, worse, AdSense. One group was even more disconnected, explaining that their goal was to build a large community of users, then they'd "figure out" how to make money.

Here's a tip for all you budding startup junkies: A busy site can certainly make for a great hobby, a fun project to fiddle with, and maybe a few bucks at the end of the month, but (with precious few exceptions) that's not a business.

Advertising? Well, you can look at the slow dissolve of the traditional media -- newspapers, magazines, radio, broadcast TV -- to understand the great risks involved in believing that someone else will always underwrite your efforts, someone other than your users. Further, while there might be high-flying estimates of future advertising revenue in the online world, it isn't often highlighted that the competition is going to get tougher too. A company like IBM might spend millions on advertising, but their money is going to skew towards a small number of large sites, not a large number of small ones, meaning that unless you want to build a business on the nickel and dime PPC payouts of Google's AdSense, AuctionAds, and related, you've got a fundamental problem in your business model.

How much smarter to have a business that has figured out a compelling value proposition, a solution that's so slick, so useful, that users are happy to upgrade to a paid premium service. Not an awkward afterthought of useless tools for the less than one percent who upgrade, but something really revolutionary, something new and clearly cool. Unfortunately, there wasn't much of that thinking embodied in the groups I met this evening, and while I remain highly enthused about TechStars, I am a bit concerned about the likelihood that we'll see a bunch of home runs, or, heck, even a single or two out of the mix...

No question, it's going to be very interesting to see how these companies evolve over the summer as various of us mentors and advisors try to hammer home the idea that the difference between a good idea and a real business is a reliable revenue stream, and that the best way to create that is to offer a compelling, valuable business service.

Then again, there are plenty of startups that were acquired without much more of a business plan than "get lots of eyeballs", so maybe I'm completely off-base here. How important do you, dear reader, believe it is that a business have a clear and sustainable revenue stream identified in the earliest stages of its existence?

[Via Dave Taylor

Previous Posts

World markets are at crunch point

eBay takes its adverts off Google

Why Advertising Isn't A Strong Business Model


Jun 14, 2007

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